The last three decades have seen a notable increase in mergers and acquisitions, as corporations focus on key areas they wish to expand, and private equity firms seek investment value across diversified industries. When executed well, carve-outs can be excellent opportunities for growth.However, the best dealmakers know that capturing the full value of the deal depends on thorough due diligence and managing the post-merger integration period.
2021 was a record-breaking period for M&A transactions as businesses emerged from the cloistered world of COVID-19 with new agendas and ambitious restructuring plans. In today's climate, a recent study by Morgan Stanley Research predicts that M&A activity is poised for a significant rebound in 2024 after a slowdown in 2023 that was largely driven by inflation concerns and high interest rates. The study predicts a 50% increase in M&A volumes compared with 2023, as concerns about inflation and the global recession ease.
The deal environment, however, is constantly shifting due to a large number of variables such as interest rates, geopolitical tensions, regulatory changes and demographic shifts.
Despite the conclusion of several high-value deals in 2023, the deal environment was dismal and global M&A volume fell by 35%. This has led to pent-up demand for lucrative deals in 2024, particularly as companies are more confident about growth after spending the past two years evaluating prospects and engaging in preliminary discussions while waiting for the market to turn. In addition, organisations are looking to improve their efficiencies and expand their market share, while private companies and private equity portfolio assets are either looking to shed assets to focus on core activities or are putting themselves up for sale (Morgan Stanley Research, March 2024).
The key to maximising carve-outs hinges on post-merger integration and how well the newly formed company manages and executes after the deal is concluded. Post-merger integration is a notoriously tricky element in M&A transactions, and the lack of clarity and/or poor execution in this phase is the most common reason why many deals fail and the return on investment is not as expected.
Integration planning should start long before the deal is announced, ideally before the buyer and seller agree on a price so that contingencies can be built into the deal framework. Buyers must conduct a realistic assessment to determine their capacity to implement and build upon the new, smaller business. This includes identifying key employees, crucial projects and products, confidential processes and gaps in resources.
This assessment will help shape the transitional services agreement (TSA) and pave the way for a smooth post-merger integration. In cross-border transactions, there are additional challenges and costs to consider, such as differences in culture, language, legal, compliance and accounting processes, to name a few.
Even after the TSA is agreed to both the buyer's and seller's satisfaction, closing the deal is only the beginning. No matter how well constructed the deal is or how compatible the companies are, if the integration phase fails, the whole transaction will fail. There is therefore a lot at stake in the first post-transaction months.
Another key phase of integration occurs after the TSA expires. While buyers are focused on merging sales and teams successfully, they often underestimate the resources needed to provide ongoing continuity in basic administrative services like payroll, finance and HR.
This briefing paper, titled " Solving the Integration Challenges Surrounding Carve-Out Transactions"produced by Harvard Business Review Analytic Services and sponsored by TMF Group, explores the intricacies of TSAs and the challenges of the post-TSA integration period in more detail.
With growth through M&A being such a high-stakes game, it's essential for companies to choose the right administrative and compliance resources to increase deal success, reduce risks and achieve efficiencies throughout the lifecycle of the transaction.
Conducting due diligence
Before buying a business, it's essential that the buyer conducts due diligence to plan for future operations.
One of the key elements is the talent management strategy. An employee's initial experience of a company is also the employer's best chance to make a good impression, thereby keeping the employee happy, productive and loyal.
In a study commissioned by TMF Group, Webster Buchanan Research spoke to global payroll managers with M&A experience at seven multinational firms, ranging from smaller startups to large global corporations. The study shows how payroll teams at different levels prepare for and manage the impact of M&As, as well as the recommended steps to take to smooth the way for employees.
The buyer's initial analysis is usually based on the limited information available to the public. As negotiations begin and the deal potential appears to be solid, the seller may offer up additional information. In carve-out deals, for example, prospective buyers will require a balance sheet and a profit and loss statement that deals only with the business division in question, giving them a good understanding of the financial condition of this unit.
Another key element critical to the structure of the deal is tax analysis. In cross-border transactions, buyers will want to minimise the taxes imposed on dividends. This means that tax queries will need to be handled on both a global and local level, ensuring compliance in the country where the new business operates as well as for the new parent company.
Doing due diligence is a time-consuming process that carries a certain amount of risk. Getting it wrong can add unforeseen costs to the transaction, potentially severely impacting the investment return down the road. For this reason, companies should look to engage an experienced partner to support them during due diligence and beyond.
A key part of the due diligence process is a detailed analysis of the potential for cost reduction and efficiencies. Opportunities for cost reduction can often be found in back- office administration processes like procurement, payroll, finance, human resources (HR) and information technology (IT).
In cross-border transactions, the deal and integration teams must account for local regulations, laws and customs in all jurisdictions where the new company will operate. It is not enough to be an expert in your industry and know the requirements for your existing business. Missing key steps due to a lack of local knowledge in a new market wastes valuable time and resources.
It is therefore crucial that the consultants involved in due diligence have extensive experience in navigating regulatory agencies and other governmental authorities in all relevant markets.
"Effective due diligence is essential to planning for the integration," said Aynsley Vaughan, Director of Global Solutions at TMF Group.
To help you avoid some of the common pitfalls associated with mergers and acquisitions, read our article on what organisations underestimate in a carve-outs and M&A transactions.
The importance of transitional services agreements
One of the most important steps - but also one of the biggest challenges – is creating the TSA.
According to Harvard Business Review Analytic Services' , "These agreements have become vital bridges to normalising operations for buyers. Under them, the seller often will continue to provide certain back office-type services for anywhere from 12 months to two years."
The report continues to explain the challenges of structuring the TSA to the advantage of both parties:
[They] heavily negotiate TSA details and terms can vary—sometimes the seller will provide the services at cost and sometimes there is a markup for the services. If the buyer needs to extend the service beyond the initial agreement, it may have to pay significantly higher service fees to do so. Both the buyer and the seller are usually eager to move away from the TSA since the seller may not have the same resources to execute the services after the sale and the buyer is reluctant to keep the seller involved in the business and keep making additional payments after having already paid a hefty sum for the business.
As early as possible in the carve-out process, both the buyer and seller should determine whether a TSA is needed. If is it, they must agree on the scope and duration. The responsibility falls on both the buyer and seller to reach an agreement on key considerations, although the buyer has more to lose if the TSA is not structured properly.
Exiting the TSA
Planning an exit strategy is one of the most important aspects of the TSA. Dealmakers must carefully assess the back-office functions that the buyer has and what it will need post-TSA. It is at this point that the buyer must decide whether it's better to build up their in-house capabilities or to outsource administrative services to a trusted partner for the long term. Outsourcing to a partner that specialises in post-merger integrations usually allows the buyer to shorten the duration of the TSA and reduces the risk as the new company begins independent operations.
In some cases, working with an external partner in the pre-transaction planning stage could eliminate the need for a TSA altogether. Buyers can benefit from the local knowledge as well as the provision of services provided by the experienced partner, both of which will remain in play at the end of the TSA. This is often a more cost-efficient and less risky way to manage the post-integration period.
The TSA clock starts ticking as soon as the paperwork is signed, and extending the coverage will add on a significant cost, you want your new compliance partner to be ready as soon as possible. If they need to recruit their own teams or service providers, the transition timeline can become prolonged and cumbersome.
Jan Willem Van Drimmelen, Chief Commercial Officer at TMF Group
Minimising the negative synergies
Executing an integration plan is one of the most difficult assignments in the M&A lifecycle.
Every merger involves some "negative synergies", including the departure of key talent, sales losses, incompatible systems, productivity declines, turf battles and cultural friction. While these can't be avoided altogether, the key is limiting the costs and preparing for any unknown challenges that may arise.
Our goal is to prevent negative synergies in mergers and position our clients for accelerated growth, enabling them to capture the full potential of the combined business as quickly as possible
Jan Willem Van Drimmelen, Chief Commercial Officer at TMF Group
The early stages of integration carry significant costs as the wide range of complex issues identified during due diligence must be efficiently navigated. M&A transactions - and especially carve-out deals - are multifaceted undertakings.
The following back-office and administrative functions are easy to overlook during implementation but are critical to the success of the transaction.
Company formation
Setting up a company is a complex process that usually requires the input of lawyers and tax advisers to assist with the structuring of the business and selecting the most appropriate legal entity. The entity type is important as it determines the in-country operating model.
You have to look at your timeline, If you have a carve-out in India and you first have to incorporate a new entity there, it will take you some time because of its local complexities. You need to keep these things in mind when setting your deadlines, especially contingencies where a group structure needs to be put in place first.
Ben Fielding, Global Head of Sales - Global Entity Management at TMF Group
Once the structure is in place, there is the question of who will handle the ongoing administrative needs of the company.
Regulatory reporting demands and complexities – and the costs of meeting them – are constantly increasing, leading many businesses to outsource essential processes so they can concentrate on core business matters.
For private equity and real estate funds, third-party administration is particularly important.
Pension funds, endowments and insurance companies want independent oversight and a segregation of duties to keep a check on the teams running the money.
Accounting and tax compliance
Different countries have different accounting and tax rules. In addition, there are regional and local tax jurisdictions within countries that companies must consider
The International Finance Reporting Standards (IFRS) is the globally accepted standard for accounting and is used in many countries with one main exception: in the US, Generally Accepted Accounting Principles (GAAP) is the accepted standard.
"Buyers often underestimate local accounting rules in newly acquired countries, and that again can lead to high unforeseen costs," Vaughan said.
HR and payroll
It's easy to overlook the human elements of a carve-out transaction. Carve-outs usually cause uncertainty within a company's talent pool, not only for redundancy potential but also for the changes that will likely be made to their working environment. Merging teams requires an active plan; people cannot simply integrate themselves.
Labour and employment requirements differ from jurisdiction to jurisdiction and sometimes from union to union. These challenges can be compounded by the scale and geographic scope of the deal.
Many countries have regulations to protect employees when the ownership of their business changes. These aim to ensure that employees are not dismissed unfairly and that the terms of their employment are not drastically altered. The new business will have to take all of this into account when deciding on the best strategy for managing HR and payroll post-integration.
After the transfer of employees takes place, a thorough onboarding programme will prevent talented individuals from leaving for greener pastures. The implementation of this programme should include clear salary structures and proper recognition of pensions and other benefits.
I think a lot of times people underestimate what needs to happen when it comes to employees, especially in highly regulated countries. Establishing and running payroll might be very difficult for you to sort out from headquarters, so you'll have to outsource it. Then you need to find a trusted provider who can do that for you and who can help you set it up.
Mark Rosson, Head of Global Payroll and HR.
Regulation and compliance
Laws and regulations are constantly changing around the world, increasing the administrative burden on smaller teams. Despite the additional stress, companies who ignore the matter do so at their peril, as noncompliance can very quickly cause financial and reputational damage and possibly the collapse of the new, post carve-out business.
In heavily regulated industries such as health care and financial services, requirements for product registrations, certifications and labelling vary by country.
It's essential that the new company develops a comprehensive plan to ensure consistent product manufacturing, distribution and sales and to retain the loyal customer base from the old entity.
To be successful, companies and private equity firms must follow a disciplined approach to integration and stick to their timelines. If the execution is well managed, the deal will begin to experience unrealised gains followed by events in which gains are realised.
"A crucial part of maintaining and generating value from a newly minted acquisition is minimising the 'slippage' costs from a bad implementation," Rosson said. "This is often not thought about or discounted in terms of level of importance."
Optimising ongoing back-office operations
The optimisation phase of a carve-out transaction is all about reducing complexity in day-to-day operations and providing critical support for the newly formed business to maintain and increase momentum.
However, the larger a deal is and the more borders it crosses, the more complicated this becomes.
The surest way to success is through local presence in the jurisdictions where the new company operates. Some countries require statutory filings to be handed over in person or contracts to be disseminated in the native language. Having people on the ground who speak the local language and truly understand the local compliance requirements will ensure that nothing is lost in translation, both literally and figuratively.
When operating in multiple markets, management should have an easy way to view all operations and processes whenever they need to, including locally compliant financial reporting and payroll systems that are set up in each country. Trying to implement global systems across multiple markets can decimate integration budgets and may still end up being ineffective.
Where there are multiple vendors involved in accounting, payroll and compliance, the coordination required can put stress on internal resources. Having one single point of contact to coordinate the day-to-day management of outsourced operations can significantly ease the load and free up time for administration teams.
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